Why Do Clever Investors Make Dumb Decisions?

Once a month I meet at a pub with a group of friends for a chat and a few beers. It’s a sort of amateur philosophical society, low on academic rigour but high on conviviality and good conversation. People occasionally bring guests along, and for a few hours we debate some of life’s interesting questions.

Last month one of our guests was an extremely bright young evangelical minister, recently graduated from Oxford University with a PhD in New Testament studies. At one point he made an interesting statement. He noted that the boundary between knowledge and faith is not always that clear. He also pointed out that desire plays a part in knowledge, in that we often choose what we want to believe.

As the discussion unfolded I saw what he was getting at. Despite the rigours of scientific research, many ’certainties’ are far from certain. They may be the best explanation of observed phenomena right now, but as our knowledge expands they may be replaced by more complete theories. So a scientist may well have faith in current explanations, without being certain that they represent ultimate truth. Or, as William James put it many years ago: "We have to live today by what truth we can get today, and be ready tomorrow to call it falsehood."

The minister’s second point was equally valid. When no absolute, objective truth exists, people choose what they want to believe. This explains why two highly intelligent people, presented with the same evidence, can draw completely different conclusions.

All very interesting, you might say, but what has this got to do with investing? Quite a lot, actually. The thing is, as a social science the theories of finance and investing do not produce clear and convincing truths. A brief comparison of knowledge in the fields of physical science and social science will make this clear.

If, for example, we were to drop a weight from a high tower, by referring to a predetermined formula the scientist can tell us how fast the weight will accelerate, and can predict with a very high degree of accuracy when it will hit the ground. By contrast, despite all of the finest theories and formulas of finance, the investment expert cannot accurately predict a future share price with any degree of confidence.

Tricks of the mind

It is this greater uncertainty in the area of finance theory that is problematical. For, when uncertainty exists, what determines what we choose to believe? It is not absolutely clear, but it appears that the rich and diverse tapestry of our past experiences and influences play a significant role. This, however, has important consequences for what we accept as knowledge.

Perhaps more worrying is the fact that hidden, subconscious factors drive certain of our decisions. Amazingly, this can happen when we believe that we are making carefully considered, perfectly rational choices! If you find this hard to believe, consider the following example.

Back in the 1980s, a young man was completing a PhD in Religious Studies at UCT. His name escapes me now, but his story has stayed with me for years. He was interested in why certain people convert from one religious faith to another, and developed a mathematical model to predict such conversions.

The model was surprisingly accurate, and the young man in question realised that ‘religion’ could be replaced by ‘brands’, ‘political allegiance’, and so on. He founded a highly successful consultancy, working with some of the world’s biggest brands and largest political movements, applying his model to predict brand switches and likely changes in political allegiance.

One would imagine that switching from one religion to another, or one political party to another, would involve much thought and consideration. Personally, I would see the final decision as being the result of a rational thought process ­- yet the mathematical model suggests otherwise. Hidden influences seem to be at play, influences that can be detected and weighed in mathematical terms to produce highly accurate predictions.

Research has shown that investment decisions can also be influenced by hidden psychological factors. We’ll take a look now at some of the more significant issues.

Reinforcing what we choose to believe

As mentioned previously, when uncertainty is a factor we choose our particular beliefs. The trouble is, not only may this choice be unwise or unhelpful, we actually go out of our way to reinforce it. When we believe something, we tend to look for data that supports that belief. And to magnify the problem, we are far more likely to reject evidence that challenges our beliefs. This is known as ‘confirmation bias’, and it leads to our chosen beliefs becoming more and more entrenched, perhaps to our detriment.

Overestimating our forecasting abilities

Many investment decisions depend on our ability to predict the future. The harsh truth is that the future is unknowable, but we fool ourselves into believing the opposite. This results from our tendency to explain the past in a coherent fashion, thereby constructing what Nassim Taleb calls a ‘narrative fallacy’. Because everything makes sense with hindsight, we believe that the future is actually knowable. We are wrong, as research study after research study proves, but it remains a very persistent and potentially damaging illusion.

Seeing patterns in randomness

One of the things that has ensured the survival of the human race is our ability to spot patterns. We are constantly scanning our environment in an attempt to make sense of it, trying to identify causes and effects, something which has helped humankind to survive and thrive. But it has also been something of a curse, as we often spot patterns where none exist.

Take for example the following random pattern, determined by flipping a coin:

OXXXOXXXOXXOOOX00XXOO

However, an investor told that the Os represent days on which a company’s share price remained unchanged, and Xs those days on which it increased, could come up with a seemingly coherent reason for such price moves, and translate it into a future trading strategy. In such a case, randomness and a narrative fallacy could be the investor’s undoing.

Jumping to conclusions

Sometimes things seem to be so obvious that we jump quickly to conclusions, only to find later that we got it wrong. Take for example the following puzzle: Four cards are lying on a table, and each has a letter on one side and a number on the other. You are asked to find out whether all cards with a vowel on the one side have an even number on the other side. The four cards facing you are marked A, B, 2 and 3. Which two cards would you turn over in order to solve the puzzle?

If you do this quickly and instinctively, you would probably choose the A and the 2 card. The reason for this is that we naturally, as mentioned above, look for evidence to confirm a theory or belief. So we pick up the A to see if it has an even number on the other side, and the 2 to check for a vowel on the flip side.

However, this confirms the theory with regard to just two of the cards. If we instead flip over the A and 3 cards, we can state with certainty whether the theory is correct in respect of all cards. Because, if there was a vowel on the back of the 3 card, this would immediately disprove the proposition.

To explain more fully, if we assume that by flipping the A and 3 cards we confirmed the proposition, this would still leave the B and 2 cards unturned. But as B is not a vowel, it doesn’t matter what number is on the flip side. And whatever letter is on the other side of the 2, does not invalidate the claim that all vowel cards have even numbers on the other side, as not all even numbers need to have vowels on the other side!

Conclusions

Forewarned is forearmed, as the saying goes. Being aware of the mental pitfalls that we are prone to should help us to avoid them - although this is by no means certain!

AJ Cillers

AJ is an academic and a freelance financial journalist who has written for Sharenet for some 15 years. He spent 25 years as an accountant and financial manager in various South African companies before moving into academia. He has a broad range of interests, including all aspects of business and stock market investing. Apart from a bachelor’s degree in Accounting, AJ holds a Master’s degree in Financial Management. He is also a Fellow of the Chartered Institute of Management Accountants.

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